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India needs to create about 20 million jobs every year which is possible only by boosting investments in ‘startups’ and ‘SMEs’. An unprecedented policy booster to promote entrepreneurship at all possible levels is the need of the hour if we want ourselves to be closer to 20 million jobs target. Both ‘startups’ and ‘SMEs’ are capital starved – despite developing VCPE funding (about $10 billion per annum) and numerous government initiatives to improving debt financing. Union budget can go a long way in bringing policy reforms to attract more capital to these important segments of economy.

It is heartening to see the government’s push for startups and the policy framework announced prior to the budget. Startups are finally getting the recognition they deserve for the disruptions to bring more efficiency in the system. The startup policy is definitely is one of the rare examples of government’s commitment to promote entrepreneurship at the startup stage

However, one must not forget the role of SMEs in creating employment across length and breadth of the country. Unlike a majority of startups that are ‘tech’ and ‘service’ focused, SMEs are conventionally more ‘manufacturing’ focused – and most definitely the founding pillar for ‘Make in India’. Thus a balanced approach towards startups and SMEs is also the key to give a balance to Indian economy in time to come.

Startup policy has many incentives for startups such as income tax break, ease of registration and exits. However, when it comes to attracting investments, the government should not differentiate between startups and SMEs. SMEs are nothing but startups in their teenage or adolescence. They are as capital starved as startups and need much policy support.

In my view, if we want to attract capital in a non-linear way, following reforms are essential with respect to attracting capital:

1. ‘Make it Simple’ – Under-legislate investments as well as exits in startups/early stage companies/MSMEs – to promote ‘Make in India (manufacturing)’, ‘Serve in India (services)’ and ‘Grow in India’ (agriculture)’

Multiple regulations and regulatory bodies have led to over-legislation pertaining to investments and exits. The legislations with respect to risk capital in the form of equity instruments should not be a function of the size of the company (startup/early stage/MSME/growth) and type of funding (angel/venture/private equity). It is not prudent to design legislations on these parameters. The government should ‘Make it Simple’ when it comes to legislations to promote ‘Make in India’, ‘Serve in India’ and ‘Grow in India’

In 2013, SEBI has issued norms for alternative investment funds (AIFs). AIFs are a newly created class of pooled-in investment vehicles for private equity, real estate and hedge funds, for change in their categories. The three categories have some specifications with respect to definition, use of funds, commitments, ticket size, taxation, etc. AIF regulations are important and can play an important role in driving governance and compliances among fund managers. However, ‘flexibility’ in investing needs to be left market-driven given the evolving nature of this industry. Investors in all three categories are investing risk capital so let the fund managers and the investee companies mutually decide the most suitable deal structure as permitted by the law.

Majority of investments in the VC/PE industry are in the startups/early stage/MSMEs/unlisted entities. The taxation on returns from these investments depends on tenure of holding as short term Vs long term (longer than 36 months holding is classified as long term), tax residency status of the investor, classification of income as business Vs capital gain.

The ideal solution to attract capital is to make long-term capital gains arising out of investment in these entities as tax-exempt irrespective of the above factors. The startup policy has indicated this but made an exemption conditional to the use of proceeds being invested in other long-term assets.

The benefits of long-term capital gain tax exemption are as follows:

It will increase attractiveness of private equity vis a vis public equity. This will bring parity of investing in this asset class (vis a vis listed entities) as well as clarity to all investors in VC/PE fund

A likely increase in participation from domestic investors (including institutions and individuals) in investing in VC/PE. Domestic money not only gives confidence to foreign investors but also act as a hedge against depreciating currency.

Incentivise foreign investors to domicile their funds in India. This will help them in monitoring the capital without worrying too much about tax implications. There is a good chance that over a period of time, they may increase India allocations.

Saving of time, money and energy for fund managers lost in grappling with taxation and structure issues – which can be productively used to focus on portfolio management and exits.

What are the pitfalls of long-term exemption on capital gains on startups/early stage/MSMEs/unlisted entities? Yes, the government will forego tax revenue. But loss of tax to the government arising out of capital gains should be seen in the following context:

Capital gains on international money is anyways (mostly) taxed outside India in the hand of investors.

Majority of the domestic institutional money is from the government institutions (like SIDBI, LIC, GIC and PSBs); so in a way, the tax loss for the IT department will be a gain for other government entities.

Profitable exits (as proportion to investments) are a few thus limiting capital gains and to that extent have not been contributing much to tax revenue of the government.

One way to reduce tax loss is to put some nominal STT (securities transaction tax) on investments in startups/SMEs/unlisted entities (like public traded companies on the stock exchange). This is also proposed by SEBI panel on VCPE reforms, headed by Narayana Murthy. Since the number of investments is far more than number of exits, STT despite nominal in nature will have much larger volume of transactions to offset the tax foregone on capital gains.

I believe that benefit of unconditional capital gain tax exemption is far too higher than the pitfall of loss of tax revenue. It will trigger a flow of capital to capital-starved entrepreneurs – which would contribute to the growth of economy as well as drive much-needed job creation.

The much-needed acceleration of flow of capital to the most vibrant sections of the economy – startups & SMEs – can be triggered with above reforms. The entrepreneurial spirit of the next union budget can take Indian entrepreneurship to the next level and set India on 10 per cent growth trajectory.